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Dr. A. K. Dey5 Goals: Reduce Cost, Improve Service By not managing inventory successfully In 1994, “IBM continues to struggle with shortages in their ThinkPad line” (WSJ, Oct 7, 1994) In 1993, “Liz Claiborne said its unexpected earning decline is the consequence of higher than anticipated excess inventory” (WSJ, July 15, 1993) In 1993, “Dell Computers predicts a loss; Stock plunges. Dell acknowledged that the company was sharply off in its forecast of demand, resulting in inventory write downs” (WSJ, August 1993)

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Dr. A. K. Dey8 EOQ: A Simple Model Book Store Mug Sales Demand is constant, at 20 units a week Fixed order cost of $12.00, no lead time Holding cost of 25% of inventory value annually Mugs cost $1.00, sell for $5.00 Question How many, when to order?

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Dr. A. K. Dey9 EOQ: A View of Inventory Note: No Stockouts Order when no inventory Order Size determines policy Inventory Order Size Avg. Inven Time

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Dr. A. K. Dey13 EOQ: Important Observations Tradeoff between set-up costs and holding costs when determining order quantity. In fact, we order so that these costs are equal per unit time Total Cost is not particularly sensitive to the optimal order quantity

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Dr. A. K. Dey14 The Effect of Demand Uncertainty Most companies treat the world as if it were predictable: Production and inventory planning are based on forecasts of demand made far in advance of the selling season Companies are aware of demand uncertainty when they create a forecast, but they design their planning process as if the forecast truly represents reality Recent technological advances have increased the level of demand uncertainty: Short product life cycles Increasing product variety

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Dr. A. K. Dey15 Demand Forecast The three principles of all forecasting techniques: Forecasting is always wrong The longer the forecast horizon the worst is the forecast Aggregate forecasts are more accurate

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Dr. A. K. Dey16 Swim Suit Sporting Goods Fashion items have short life cycles, high variety of competitors Swim Suit Sporting Goods New designs are completed One production opportunity Based on past sales, knowledge of the industry, and economic conditions, the marketing department has a probabilistic forecast The forecast averages about 13,000, but there is a chance that demand will be greater or less than this.

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Dr. A. K. Dey21 Key questions What is the best production quantity? How much is the profit if there is no beginning inventory, manufacturer produces 12000 swimsuits while the demand is 13000 swimsuits? Calculate the profit if the company produces 12000 swimsuits and the demand is for 11000 swimsuits.

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Dr. A. K. Dey26 Swim Suit Best Solution Find order quantity that maximizes weighted average profit. Question: Will this quantity be less than, equal to, or greater than average demand?

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Dr. A. K. Dey27 What to Make? Question: Will this quantity be less than, equal to, or greater than average demand? Average demand is 13,100 Look at marginal cost Vs. marginal profit if extra jacket sold, profit is 125-80 = 45 if not sold, cost is 80-20 = 60 So we will make less than average

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Dr. A. K. Dey30 Effect of Initial Inventory Suppose the beginning inventory is 5000 swimsuits If does not produce – max 5000 swimsuits can be sold If starts production, fixed cost will be charged Assuming same demand pattern Should the manufacturer start production? If yes, how many swimsuits should be produced?

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Dr. A. K. Dey33 Key Insights from this Model The optimal order quantity is not necessarily equal to average forecast demand The optimal quantity depends on the relationship between marginal profit and marginal cost As order quantity increases, average profit first increases and then decreases As production quantity increases, risk increases. In other words, the probability of large gains and of large losses increases